1973 was perhaps the most important year in the history of options. It was the year when Fischer Black and Myron Scholes came out with a definite mathematical formula to price options, commonly known as the Black–Scholes formula, in their paper, ‘The Pricing of Options and Corporate Liabilities’. The very same year, Chicago Board Options Exchange (CBOE) came into existence and started offering options as a tradable financial instrument. Ever since 1973, option trading has grown by leaps and bounds and the number of option traders has grown exponentially. While in the first three decades this growth was majorly led by institutional investors, in the last decade one has seen exponential growth in retail options traders. According to data available from The Options Clearing Corporation, the volume of options contract traded in January 2015 were more than 358 million, significantly above the 313 million traded in January 2010.
The Option Industry Council published a paper titled, ‘A 15-Year Comparison of Options Investors’ in 2010, which highlights the growing trend among savvy retail investors to use options for both hedging their portfolio and making short-term gains. According to the study, 80 percent of option traders consider themselves to be ‘extremely knowledgeable investors’ and 54 percent of option investors consider investing to be more than a hobby and an important part of their life, compared to 38 percent investors who don’t use options. The study also highlighted how 75 percent of non-option traders don’t trade options due to lack of knowledge and in spite of that, 47 percent of them showed interest in trading options in the future.
So, what’s driving this growth of option trading among retail traders? Needless to say, it is a combination of the benefits of trading in options that retail investors have gradually started to recognize, diminishing of the technology gap between retail traders and institutions, and the easy availability of free trading and educational tools for retail options traders.
Options, by default, are leverage instruments, i.e. they allow investors to increase the potential return by employing the same amount of capital; but they are in a way a good form of leverage. The reason we call it a good form of leverage is because instead of other common leverage measures like borrowing on margin, where interest is charged and losses can be significant (even in excess of the capital), buying options limits the maximum possible loss that can be incurred by the trader to the capital deployed in buying those options.
To elaborate on this, let’s take the example of investor A and investor B, both of who are bullish for the short-term on stock XYZ, which currently trades at $100. Investor A purchases 100 shares of XYZ by putting in $10,000, while investor B purchases a 102.5 strike call of XYZ, which trades at $2 by putting in $200 (assuming 1 option contract = 100 units). Now let’s say, at the time of options expiry stock X trades at $110. Investor A would have made a profit of $1,000 by investing $10,000, a return of 10 percent, while investor B would have made a profit of $550 [(110-102.5) x100 – 200] by investing only $200, a staggering return of 250 percent. Let us also assume the scenario when instead of going up, shares of XYZ tanked to $90 at the time of expiry, while investor A would be sitting on a loss of $1,000, all that investor B would have lost will be his initial investment of $200.
While this is a traditional example of option leverage, the previous example ignores the probability of profit for the contracts. Investor B, who purchases the call contract, has a break-even price of $104.50 (102.5 Strike plus the option premium cost of $2). So while the investor has dramatically increased his leverage, his likelihood of losing the $200 is high.
This is why the remaining benefit of option trading, which involves selling options vs. buying, is particularly attractive.
While investments in stocks generally take a long time to be fruitful, options give retail investors an edge by allowing them to collect regular income from their portfolios. Simple options strategies like writing covered calls enables investors to make small income on their investments, even if the stock goes nowhere.
For example if an investor owns 100 shares of company XYZ, trading at $50, and sells a 52.5 strike call option of the stock priced at let’s say $2, if the stock goes nowhere and closes at $50 on expiry day, the investor would still make a gain of $200 from the premium collected by selling the call. This strategy also reduces overall risk of the portfolio as it reduces the breakeven of the investment for the investor from $50 to $48 (excluding brokerage).
Investors can also use options to buy a stock at a lower price than where it currently trades by using cash secured put writing. To elaborate on this, let us take the same example of company XYZ trading at $50. Here, if one wants to buy 100 shares of the company it will require an upfront investment of $5,000. However, instead of directly buying the shares, the investor can write 47.5 strike put option of stock at, let’s say $2. Now, if the stock moves up, the investor would still make $200 from the option trade and if the stock moves lower even to $45.5, the investor won’t incur any loss, but rather get a chance to buy the stock cheaper.
Trend, they say is the most important requirement for a trader to make money in the markets. Mabe you’ve heard: “The trend is your friend… until it ends”. However, for option traders, unlike other traders, that rule and adage doesn’t apply. This is because options give them the liberty to make money even when the markets are trendless or basically lack the required volatility to make a direction-based trade. These are the trades we primarily focus on and are the best candidates to apply the advanced mathematics of MCDM.
Apart from the strike price, time for expiration and risk-free interest rate, volatility is another important factor that goes into pricing of an option – more the volatility higher the option price and vice versa. The change in price of an option (everything else remaining constant) for a 1 percent change in the volatility of the underlying asset is known as Vega. The flowing table illustrates how the most common direction-based option trades are affected by change in the IV (implied volatility)
| Vega Sign | Rise in IV | Fall in IV | |
|---|---|---|---|
| Short Strangle | Negative | Lose | Gain |
| Short Strangle | Negative | Lose | Gain |
| Long Strangle | Positive | Gain | Lose |
| Long Straddle | Positive | Gain | Lose |
| Backspread | Positive | Gain | Lose |
| Ratio Spread | Negative | Lose | Gain |
| Credit Spread | Negative | Lose | Gain |
| Debit Spread | Positive | Gain | Lose |
| Butterfly Spread | Negative | Lose | Gain |
| Calendar Spread | Positive | Lose | Gain |
Back in the day, when large institutions based in New York were the only players with instant access to markets, an average investor had to wait for the daily newspaper to check stock quotes and then call or visit his broker’s office to place a trade. Slowly, with the penetration of television and then 24×7 businesses news channels that process eased up significantly and now, with internet and gadgets becoming an integral part of our lives, we are in a time when there is, if any, very little technological edge that a hedge fund manager based in Connecticut has, over say a retail trader based in rural Minnesota.
Real time quotes, superior charting software, instant news-feed, back testing tools, online trading terminal providing immediate execution, almost everything that’s needed to make an informed trading decision are now available to average investors at a fraction of what they used to cost a few years ago.
OptionAutomator’s Brutus Option Ranker is the next evolution of free tools to add to the options trader’s arsenal. By applying decision-making mathematics, Brutus can find your best trade candidates against your trading criteria without you spending hours behind the computer screen.
One can also argue that in some ways the advancement in technology has actually made it harder for institutional investors to compete with a retail trader today than the other way round. A retail trader now has the ability to be much more flexible and nimble, getting in and out of trades with relative ease, something that is just not possible for institutional investors to do with their large-sized trades.
As the study conducted by the Option Industry Council pointed out, lack of knowledge regarding options was the reason why 75 percent of non-option traders don’t trade in options. With the easy availability of free tools and educational resources online and offline, this gap is getting bridged. Several brokerages run free training programs for investors who want to understand options and trade in them. One can also download e-books, podcasts, videos related to options online. Moreover, several accomplished option traders write blogs and posts videos on sites like YouTube through which a novice option trader can understand the dynamics of the option market and mulate successful trading strategies.
In addition to free hedge-fund quality tools to find your best trades, OptionAutomator aims to provide great educational resources via our own blog and by collecting the very best resources on the net for our readers.
Easy availability of free tools and educational resources along with the diminishing of technology gap between institutional investors and retail investors has played a significant role in bringing options trading from the realms of sophisticated traders to the reach of an average investor and that’s why perhaps, there has never been a better time to be an option trader than now.
